FERRIER INTERNATIONAL thanks Cees Bruggemans, Chief Economist of FNB for this article which we share with you.
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Fundamental disagreements
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| By Cees Bruggemans, Chief Economist FNB |
| 17 March 2009 |
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How to save the world? It is a fundamental question. But instead of growing convergence in thinking and policy prescriptions around the world, there appear crucial dimensions in which there is growing disagreement about what to do next. If such disagreement were to go too far, it could have fatal consequences. We note disagreements between central banks (serious), between governments (very serious), between academics (serious for future historians), between forecasters (serious for current reputations) and probably between husbands and wives (watching too much or too little telly, depending). Central banks seem to have started to criticize each other. There isn’t any blatant name-calling going on, but there seems to be this high-road low-road business, one party claiming we-will-do-this, with another saying quite succinctly we-will-never-do-that. Does it matter? It could. Anglo-Saxons, along with the Swiss (and Swedes), seem joined at the hip about taking interest rates down to near zero, and to move next to quantitative easing, described by some as basically credit easing. The aim is to get lending going again. In the case of the Swiss (and the Swedes), there is the additional aim of getting a strong home currency to weaken, protecting the home economy under increasingly dire circumstances. These central banks have lowered interest rates to near zero in the hope of pulling effective interest rates in the economy to low levels despite very wide spreads. It also has induced certain central banks to start making credit markets of their own (for commercial paper, auto loans, credit cards, student loans) where such markets have ceased to exist. As to quantitative easing, large quantities of fixed income bonds (publicly and corporate issued) are held in private institutional hands. By buying such bonds on a large scale, Anglo-Saxon central banks could be doing various things. They will drive up the price of such bonds, lowering their yields. And they will inject a lot of cash into the financial markets, increasing the cash holdings on banks balance sheets. With banks still very distrustful and not really wanting to lend out money to risky customers, but with bond yields still attractively high, any increase in their cash holdings would induce banks to buy more bonds. By reducing bond attractiveness (falling yields), while loading the banking system with cash (the Bank of England for instance wanting to expand the British monetary base very quickly by 80%), with no low-risk reasonable return investment alternatives available to them, the idea is to prompt banks to start lending again to more risky but also higher return borrowers. Initially, this won’t quite work as banks will prefer to safely hoard cash/liquidity rather than start lending. But as the cash mountain grows and grows (a rising tide), watch out for a gradual breakdown in hoarding as banks get pushed to do something with what is ultimately still relatively expensive cash. And so the Fed and BOE are starting to buy bonds, although there could be leakage. Many bonds are held by foreigners, and buying from them could inflate the cash deposits of their home banks, while putting downward pressure on one’s own home currency ( Ideally, all major central banks would undertake such actions at the same time, neutralizing such leakage effects on each other, while collectively pumping up the global financial system. But the ECB specifically doesn’t want to go there, or so it is still saying today. Some of its leading elements see it more like an invitation of blowing up the world. Not for them, it seems. The Anglo-Saxons see the danger of The Europeans seem to fear too much money creation and new types of financial instability. This doesn’t seem to face the Anglo-Saxons. Credit has to start flowing again, and any involuntary unwillingness among private banks needs to be forcefully addressed. This is aside of bank capital adequacy needing to be improved and impaired (toxic, reduced-value) assets needing to be written down. This is being addressed separately through bank nationalizations (partial and otherwise) and public capital injections (which are issues for national treasuries and their governments to address, mobilizing their tax bases). In the short term, even more serious is the apparent difference between governments concerning their roles and what they need to do most urgently. Some (especially Europeans with some emerging markets in tow) want to focus on getting financial market regulations tightened as soon as possible (along with governance changes to international lending agencies). Others, especially Americans, seem to think this very important but not an immediate urgency (Heaven Can Wait). The immediate priority for the latter is to keep effective demand in the world economy sufficiently high even as households deleverage (cut spending in favour of saving) and many corporates defensively cut inventories, fixed investment and labour forces. Thus, the Others, with histories of painfully restoring their national finances to health after wide irresponsible detours, often ideologically induced, aren’t so keen. One example is This is in part a free rider problem, with little and not so little guys wanting to do as little as possible, hoping to keep their finances healthy and limiting future burdens while the big guy does the heavy lifting and pays the potential long term price of impaired finances and competitiveness. There is a touch of righteousness here (the Americans created this problem, let them catch the falling knife), but it is more than this. For some it is ideological, not wanting to sacrifice one’s long term financial health for uncertain short-term gains. Yet it is precisely the Keynesian insight about all being dead in the long term that prescribes focusing on the short term if one wants to prevent enormous economic pain from being incurred for a very long time due to inadequate demand settling in and not easily being budged. These tiffs extend into academia but also along the political spectrum. In the US, the Republicans are the righteous defenders of the neo-classical faith, whose mantra is a simple one – stability is the central assumption, and any investment mistakes should be allowed to be washed out, so that the system can rise off its own bat, purged, lean and mean and roaring to go. But as Larry Summers puts it, “this notion that the economy is self-stabilising is usually right but it is wrong a few times a century. And this is one of those times ……… there is a need for extraordinary public action at those times”. The philosophical divide extends deeply into academia. Both neo-classical and New Keynesian macroeconomic frameworks depend on rational expectations, fed by the Great Moderation of post-WW2 decades in which there ultimately no longer proved to be space for uncertainty. Philosophically, information is freely fed into these models from the outside. In the neo-classical case it is the Walrasian Auctioneer and for New Keynesians it is the information generated by the model. Effectively this is the same thing, if subtly different. The bottom line in both approaches is that uncertainty cannot exist. It isn’t possible to encounter something as is currently entertaining the world daily. Both approaches advise that the financial and economic system will recover by itself under all circumstances. In contrast, government intervention is seen as always fatal, being castigated as a source of instability. Yet sometimes enormous shocks can develop, coming from the outside, so big that uncertainty becomes an overwhelming reality from which it is difficult recovering, as Summers put it so succinctly. It is at such moments that the only party not usually subject to uncertainty and its paralyzing fears is the state, it not being guided by commercial considerations. At which point the state can play saviour if it understands the situation and the contribution only it can offer when all have withdrawn to the sidelines, refusing to dance. Thus, the contrary view to both neo-classical and New Keynesian offerings is that reality isn’t mostly stable. The opposite is true. Real life per definition is unstable. If events reduce risk-taking and effective demand, these reactions may ultimately prove large enough such as to induce paralysis, both taking very long coming back under their own steam. A global majority today favours being proactive and supportive rather than standing back. Still, it is an important divide, and may prevent as much of a global effort, and soon enough, that would limit the transition cost of getting fully back on stream. This feeds reputation risk for legions of forecasters reading the tealeaves and advising their clients. Will the world descent into depression and deflationary feedback loops as all fall down and little can be done to prevent it happening, taking years if not decades to fully come back from such disaster? Then there are those who are simply skeptical about financial repair efforts (it takes oodles of time sorting out banks), about government actions (getting fiscal stimulus agreed and enacted), about what Anglo-Saxon central banks think they are doing (inflating their balance sheets and potentially laying the foundation for the next great financial disruption via currencies and inflation), and what the huge government debt enlargement will do to private capital markets. All of this takes time, a lot is experimental, some of it won’t work, and confidence will take time to be restored. Ergo, don’t hold your breath, as this will take more than a few quarters to get right (more likely years, if not decades). Finally, there is the simple quarterly forecast modeling inventory drawdowns (always coming to an end), fiscal injections (always showing up, however weak), credit system repair and resumption of bank lending. And, most crucially, the gradual return of confidence (or rather the slow subsidence of fear). After maximum car replacement delay, big fixed investment cuts, inventory drawdowns and labour force shedding, the economy stabilizes and then starts to respond favourably to lower energy prices, slashed interest rates, huge fiscal injections and major currency changes. And critically there can be observed a change in sentiment as bank repair at some point is seen to be working, led joyfully by equity markets rising. Fear (paralysis) starts to subside. After writing off a few quarters, admittedly more of them and much deeper than usual, it is time to get back on track. In this fashion, the US entered recession in late 2007, fell of a cliff in 4Q2008, will explore even lower levels of deprivation in 1H2009, and should be coming up for air in 2H2009, positive growth resuming in 2010. This is of course a rolling forecast, with every passing month, and quarter, creating new opportunity to extend the forecast yet more as reality is turning out to be a good deal more horrendous than ever imagined. But then what did you expect? “They” blew up the world, meaning the banking system and with it a few other things, such as housing, insurance, equity markets, a few pension plans and companies, and much more besides. It takes time, effort, ingenuity and political will to come back from that. And the world is doing so, though not quite unified about how to do so in the fastest possible time with the least sacrifice. And so we are still exploring the full extent of this shock and the loss it will impose on us before normality is restored and life can resume its reach for the stars. As to any cyclical upturn commencing, it could still be before this Christmas, with President Obama having something real to promise this coming Thanksgiving, besides traditionally reprieving one lucky token turkey. And so we watch Bernanke, King and Trichet with morbid fascination, and with deep skepticism follow Geithner, Darling and a few others, with the orchestra of politicians (Obama, Merkel, Brown, Sarky and a supporting G20 cast of thousands) doing the directing. Would it have been different under Hillary? No. McCain? Definitely. Count your blessings, this coming X-mas. Only 275 more sleepies to go.-? -?-?-?-? Cees Bruggemans is Chief Economist of First National Bank. 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